Should You Bother With Individual Bonds?

I like investing in debt. Prices are more stable, so are returns. It gives you exposure to an entirely different asset class, a class that performs pretty much inversely to stocks.

Debt comes in many forms. You could buy mortgage debt, government debt, corporate debt or the much riskier corporate debt, junk bonds. You can also buy convertible debentures, municipal bonds, real return bonds and lend money to regular people through social lending websites. The world of debt is absolutely massive, and that doesn’t even count preferred shares.

With all these options, how does the average person include debt in their portfolio?

My favorite method is to buy individual preferred shares. While they’re somewhat illiquid, they can easily be traded by the retail investor. Typically they hover between the $20 and $25 range, meaning an investor can buy a block at a much more reasonable price than buying a block of bonds.

If someone has $20,000 to put towards debt, they could easily buy 8 different preferred shares in 8 different sectors. Is that diversified enough? If one company gets hammered and goes to zero, 12.5% of the portfolio gets wiped out. I’m confident that the preferred shares I’m invested in are from only high quality companies, but an investor is taking on some risk by only holding a handful of prefs.

What’s an investor to do? Luckily, the market has come up with a great solution. Bond ETFs.

I absolutely love bond ETFs. You can buy everything in the risk spectrum from short term government debt to high risk junk bonds and everything in between. They offer instant diversification and if you’re willing to buy into some of the riskier issues you can earn double digit yields.

Personally I hold some shares in a closed end fund called the Dreyfuss High Yield Strategies Fund. This is an interesting play, as they use leverage to help amplify returns. The fund currently pays out a hair less than 10% and I’m sitting on a comfortable gain over the $3.00 purchase price, a nice return once you include the income distribution. This fund is definitely on the higher end of the risk spectrum in the world of debt.

I’m not smart enough to try to trade debt. Yes, interest rates will be going up soon, probably having a negative effect on bond prices. If you’re smarter than me then perhaps you can figure out how to use that information to make money. I’ll just buy a good fund of debt at a yield I’m happy with and hold it long term.

This begs another question: at what point should you sell your debt? I have a nice sized capital gain on my Dreyfus fund. Is it time to sell and lock in profits?

Knowing when to sell is always a tough decision. I think that if you look at your bond fund and you wouldn’t buy it because the yield is too low then maybe it’s time to sell.

2 Comments

Good post, and spot on with the comment on what true diversification means and how ETFs and funds really accomplish that.

One thing to keep in mind about individual (non-callable) issues, though, is that they protect us against deflation unlike a fund or ETF. Which is especially currently this is important, but it's also part of a solid overall strategy.

Having Treasuries and agencies for income earning assets thrive in deflationary times, long term fixed mortgages in a personal residence protect against inflation, and equities thrive in prosperous times.